137

Chapter 5

THE EFFECTS AND POLICY IMPLICATIONS OF

BASEL III IN KOREA

By

Jinshik Son1

1. Introduction

Since the recent outbreak of the transatlantic financial crisis, there have

been various responses aimed at preventing another shock and remedying

the deficiencies in the existing financial system. As part of these efforts, the

Basel Committee on Banking Supervision (BCBS) decided in 2010 to

implement a new international regulatory framework for banks (also called

Basel III) from 2013.

It is said that the new regulatory framework has two core tasks:

enhancing the micro-prudential rules in Basel II and adopting a macro-

prudential overlay. For its micro-prudential purpose, Basel III introduces

liquidity standards, enhances capital regulations, and implements leverage

ratio regulations. And for its macro-prudential purpose, Basel III introduces

a countercyclical capital buffer, as well as the regulation for systemically

important financial institutions (SIFIs).

These rules are designed to affect the levels of bank liquidity and capital

in accordance with certain specific priorities. Considering the roles and

positions of banks in their economies, it is easy to expect that the regulations

may not only directly affect banks but also indirectly affect the overall financial

and economic conditions.

It is thus necessary to examine the effects of this global regulatory

innovation on bank management, the financial markets and the real economy

in order to minimise the side- effects of the regulations. This paper purposes

to analyse the effects in implementing Basel III in Korea, especially with

regard to the liquidity standards and capital regulation, and attempts to

________________

1. Economist, Banking Research Team, Macroprudential Analysis Department, The Bank

of Korea. The views expressed in this paper are those of the author, and do not

necessarily reflect the stance of The Bank of Korea or The SEACEN Centre.

138

measure the impacts of the countercyclical buffer. It also makes several

policy suggestions based on the findings of the analysis.

Section 2 provides a summary of the Korean financial system and

evaluates recent potential risks from a macro-prudential point of view. Section

3 describes the current status of compliance with the global financial

regulations in Korea from the aspects of the capital regulation and liquidity

standards. Sections 4 and 5 are devoted to analysing the effects of capital

regulation and the liquidity standards from the standpoints of the Korean

banks’ behaviour, the financial markets and the real sector. Section 6 then

suggests several policy recommendations on the basis of the above analysis.

2. Overview of Korean Financial Systems and Risk Assessment

2.1 Financial Institutions

Financial institutions serve mainly as intermediaries for savings and

investment between savers and borrowers, and are commonly divided into

six categories: banks, non-bank depository institutions, financial investment

business entities, insurance companies, other financial institutions, and financial

auxiliary institutions.

To elaborate on the financial institutions making up each category under

this classification, banks are divided into commercial banks and specialised

banks. Commercial banks consist of nationwide and local banks and branches

of foreign banks. Specialised banks are financial institutions established under

a special act rather than the Banking Act, and their main enterprises are

banking businesses. Specialised banks include the Korea Development Bank,

the Export-Import Bank of Korea, the Industrial Bank of Korea, the National

Agricultural Cooperative Federation, the National Federation of Fisheries

Cooperatives, and others.

The non-bank depository institutions mainly concern themselves with

taking deposits and lending, similar to banks, but are established for more

limited purposes. This makes them subject to different regulations concerning

the raising and management of funds than those of banks. That is, the scope

of their business activities is narrower than that of banks, payment and

settlement services are either non-existent or provided for in a limited manner,

and the focuses of their businesses are restricted in advance in accordance

with each financial institution’s unique features. Non-bank depository

institutions comprise mutual savings banks, credit cooperatives, including credit

139

unions, community credit cooperatives and mutual banking entities, merchant

banks and the postal savings.

Financial investment business entities include all the financial institutions

that primarily conduct the business of trading marketable securities in the

direct financing markets. These consist of investment traders and brokers

(securities and futures companies), collective investment business entities,

investment advisory and discretionary investment business entities, and trust

business entities.

Insurance companies are those institutions that underwrite and operate

insurance against death, disease, old age, or a variety of accidents, including

fires. Based on the features of the institutions and their businesses, they are

categorised into entities providing life insurance, non-life insurance, postal

insurance, mutual aid, and others. Non-life insurance companies consist of

property and casualty insurance companies, reinsurance companies, and

guarantee insurance companies.

Other financial institutions include institutions mainly operating financial

businesses that are difficult to classify among the financial institutions in the

four aforementioned categories. They consist of specialised credit financial

companies (leasing, credit card, installment financing, and new technology

venture capital companies), venture capital companies (small- and medium-

sized enterprise establishment investment companies), securities finance

companies, the Korea Deposit Insurance Corporation, public financial

institutions, and others.

Financial auxiliary institutions are those institutions that, rather than

directly taking part in financial transactions, mainly provide the conditions

necessary for the smooth operation of the financial system. They span

institutions carrying out businesses related to financial infrastructure, such

as the Financial Supervisory Service, the Korea Financial Telecommunications

and Clearings Institute and the Korea Securities Depository; the Korea

Exchange; credit guarantee institutions, including the Korea Credit Guarantee

Fund and the Korea Technology Finance Corporation; credit information

companies; financial brokerage companies; and others.

140

2.2 Financial Markets

Financial markets are organised venues where the economic players

may raise the needed funds and operate residual funds through transactions

in financial instruments. Firstly, the financial markets are divided into direct

and indirect financing markets, depending whether the transactions are

conducted through financial intermediaries. The indirect financing markets

are exchanges where funds are brokered through deposits and loans; the

deposits and loans market is a good example. Financial transactions are carried

out by banks, non-bank depository institutions, collective investment business

entities, trust business entities, etc., that provide funds by lending money or

by buying direct securities with funds raised through indirect securities, such

as certificates of deposit and beneficiary certificates. Financial transactions

in the direct financing markets are undertaken as the fund providers purchase

direct or primary securities issued by the end consumers of the funds, such

as financial debentures or corporate bonds. Accordingly, the direct financing

markets, which do not depend on financial intermediaries, play more active

roles and are more diversified than the indirect financing markets.

141

Table 1

Financial Institutions in Korea

(As of end-September 2011)

142

In accordance with the maturities of the financial instruments involved,

the direct financing markets are generally divided into the money markets

and the capital markets. Additionally, they can be divided into the foreign

exchange markets and the financial derivatives markets, based on the features

of the financial instruments concerned.

The money markets are those markets where financial instruments that

expire within one year are commonly transacted in order to maintain the

balance of supply of and demand for short-term funds. The money markets

in Korea embrace the call market, as well as a wide range of other financial

markets including those for commercial paper (CP), certificates of deposit

(CDs), repurchase agreements (RPs), monetary stabilisation bonds (MSBs)

and cover bills (CBs).

The capital markets are the markets where the means to raise long-

term funds, such as stocks and bonds, are issued and transacted. These are

usually categorised into the stock market and the bond market. The secondary

stock market is further divided into the marketable securities market and the

KOSDAQ, where listed stocks are traded, and the Free Board for unlisted

stocks. The bond market is where long-term bonds with maturities greater

than one year are issued and traded. The secondary bond market is divided

into the face-to-face market (marketable securities market) where listed bonds

are traded, and the off-board market where all bonds including unlisted bonds

can be transacted. The capital markets include the newly emerging asset-

backed securities market, which is seen as a means for companies and

financial institutions to mobilise funds. This market is where asset-backed

securities (ABSs) issued based on illiquid assets such as properties, accounts

receivable and mortgage-backed securities, are traded.

The foreign exchange market is the place where the regular or continuous

trading of foreign currencies takes place between foreign currency purchasers

and suppliers. The foreign exchange market is divided between the customer

market, where foreign currency is traded between general consumers and

foreign exchange banks, and the inter-bank market, where foreign currency

is transferred between foreign exchange banks. However, the foreign

exchange market most commonly refers to the inter-bank market, as this is

where the basic exchange rate is determined.

143

The financial derivatives market is the place where financial derivatives

designed to reduce the risk of changes in the value of underlying assets can

be traded. The financial derivatives market in Korea consists of the market

for stock, interest rate and currency derivatives, together with the credit

derivatives market and the derivative-linked securities market.

Chart 1

Structure of Financial Markets in Korea

144

2.3 Risk Oversight Assessment and Vulnerabilities

The Korean financial system remained generally stable, although

conditions at home and abroad worsened mostly due to the accumulation of

household debt and the fallout from the sovereign debt crisis in Europe. The

resilience of the financial system was heightened as the soundness of banks,

which make up the backbone of the financial system, improved, boosted by

large-scale net profits, and as foreign exchange soundness remained on a

trend of improvement, the result of the steps taken to enhance macro-

prudential soundness, including imposition of the Macro-prudential Stability

Levy on non-core foreign currency deposits. In addition, the volatility of

financial market price variables stabilised at a low level. This stable state

of the financial system is well-represented in the financial stability map.

In the international financial markets, instability appears to have eased

since the beginning of 2012, primarily on the back of the progress made in

discussions on resolving the sovereign debt problems in Europe and the

ongoing expansive monetary policy stances on the parts of the ECB and

other central banks of major countries. As the tendency toward risk aversion

has moderated in line with the ample global liquidity, the VIX, an indicator

of global financial market volatility, has maintained a downward trend and

the Euribor-OIS spread, a measure of credit risk in the European money

markets, has also narrowed.

Long-term interest rates in the major countries have remained at low

levels after falling sharply in August 2011 on concerns about a weakening

of the business recovery, but more recently they have risen slightly. Stock

prices shifted to an uptrend upon the ECB’s supply of long-term liquidity in

December 2011 and the consequent soothing of market unrest.

145

Chart 2

World economic growth is slowing down, as the business recovery in the

advanced countries weakens and the impact of this development spread to the

emerging market countries. The US economy is sustaining a moderate trend of

recovery, helped mostly by an increase in corporate investment. However, factors

such as the increase in long-term unemployment, the continued housing market

slump, and worries over snags in the pursuit of fiscal consolidation are preventing

the recovery from gaining traction. The euro area economy appears set on a

low growth path for a considerable period, as the effects of the sovereign debt

crisis feed through to the economies of the core euro area countries, including

Germany, by way of financial market unrest and the waning confidence of

economic agents.

The economies of the emerging market countries, including China, have

seen their pace of growth slacken markedly since the second half of 2011, due

to the deteriorating export climate brought about by the weakening trends of

recovery in the advanced economies. There are concerns about growth slowdown

in the coming months as well, owing mostly to continuation of the low growth

trend of the euro area economy and to an additional run-up in the international

oil prices.

146

In the Korean economy, the trend of growth appears to be slackening, owing

chiefly to continued uncertainty in the external conditions and the consequent

erosion of investment and consumer confidence. The domestic economy is

expected to post quarter-on-quarter growth rates of around 1% in the first half

of 2012, pulling out of its sluggishness in the fourth quarter of 2011. It is forecasted

to subsequently show a rising trend from the second half onward, albeit modestly,

as external uncertainties moderate. Uncertainty as to the growth path remains,

however, stemming mostly from the run-up in international oil prices and slowing

growth in China and other emerging market countries.

Household debt continues to rise, led by non-bank lenders and low-income

borrowers. The possibility of household loans turning sour on a large-scale in

the short term does not seem high, however, given that the overall level of

delinquency rates on household loans is still low (0.7% for banks, as of year-

end 2011) and that the loan-to-value (LTV) ratios of mortgage loans are also

low. Meanwhile, in line with the mounting debts of borrowers in the low income

brackets, amid the intensifying polarisation of household incomes, the risks of

these households with their low debt-servicing capacities going into distress could

rise.

In the corporate sector, financial soundness is found to have declined on the

whole, with profitability falling and cash generating capacity also weakening due

to the slowdown in world economy activity and to lackluster domestic demand.

Chart 3

147

In the real estate market, the divergent movements across the regions

continued, with housing prices appearing to weaken in Seoul and its surrounding

areas, centering round large housing units, while in contrast exhibiting a steep

upward trend in the provinces. This rapid housing price rise in the provincial

areas is considered to be attributable mainly to a contraction in the supply of

available housing and to the translation of demand for housing on a leasehold

deposit basis into demand for outright purchases following the steep run in

leasehold deposit prices. Downside risks to housing prices in Seoul and its

surrounding areas predominate, including the limitations on incomes due to the

business slowdown and the weakening of home-buying sentiment. Under these

conditions, housing prices could fall steeply in a short period of time in case of

any unexpected shock. There are fears in the event of such a case about

insolvencies among households that have borrowed excessively relative to their

incomes in anticipation of rising prices.

The household debts of borrowers have been increasing in the provinces,

centering around borrowings from the non-banking sector, in tandem with the

huge rise in housing prices there. The household debt problem consequently

appears to be spreading from the Seoul metropolitan area to the provinces and

from the banking to the non-banking sector.

Chart 4

148

In the banking sector, asset soundness has been enhanced by the large-

scale sales and write-offs of troubled assets amid smooth funding conditions. In

addition, as profitability improved, capital adequacy also maintained a

comparatively favourable level.

In the non-banking sector, there are concerns about a deterioration of

management soundness in certain sub-sectors. Mutual savings banks are

experiencing difficulties because of their lackluster business performances. In

the event of a further souring of real estate project financing (PF) loans, coupled

with deterioration in the soundness of unsecured household loans which have

recently been surging, insolvency problems at savings banks could once again

come to the fore.

The household loans of mutual credit companies (agricultural, fisheries and

forestry cooperatives, credit unions and community credit cooperatives) are

increasing rapidly, facilitated for instance by cutback of the banking sector in

household lending. There is a possibility of these loans becoming distressed on

a large scale if the improvement in household incomes is delayed, since some

mutual credit companies are showing signs of worsening asset soundness.

Chart 5

149

Chart 6

The Korean financial markets have presented a relatively stable picture,

with reduced price variable volatility for example, as the international financial

market unrest has eased entering 2012. Treasury bond (3-year) yields have

been fluctuating within a narrow range at around the mid-3% level, influenced

chiefly by global financial market conditions and foreign investor transactions.

The main stock price index (KOSPI) fluctuated, after having fallen sharply

from August 2011 in response mostly to the US sovereign credit rating

downgrade and the resurfacing of the euro area sovereign debt crisis, but

then shifted to an upward track from the beginning of 2012. The won/dollar

exchange rate showed an upward trend from September 2011 due to the

international financial market unrest, but has since early 2012 maintained a

downward trend by and large.

Foreign exchange soundness appears favourable on the whole, with

foreign exchange reserves and net external assets increasing and the external

debt servicing capacity rising. The ability to repay short-term external debt

has been enhanced as the ratio of short-term external debt to foreign exchange

reserves has declined, while the ratio of total external debt to GDP, indicative

of a nation’s external debt servicing capacity, has been maintained at a stable

level. Meanwhile, with the fall in short-term external debt, the external debt

profile has also improved, as seen for instance in the declining weight of

short-term total external debt.

150

Chart 7

In response to the mounting uncertainties at home and abroad, the Bank

of Korea (BOK) prepared a wide range of policy initiatives for the

maintenance of financial system stability and pursued them actively. As a

first step, the BOK sought to heighten the macro-prudential soundness of

the foreign exchange sector. It took measures, in consultation with the

government, to alleviate capital flow volatility – including lowering the ceilings

on the forward exchange positions allowed at foreign exchange banks and

restricting the institutions handling foreign exchange business in their

investment in foreign currency-denominated bonds issued domestically for

Korean won funding purposes. The relevant regulations were in addition

realigned to facilitate seamless implementation of the Macro-prudential

Stability Levy. Along with this, in order to heighten the capacity for responding

to overseas shocks, the currency swap arrangements with Japan and China

were also enlarged.

Although financial system stability is being maintained in Korea, thanks

mostly to the policy efforts of the BOK and the government, the latent risk

factors are as ever present – including the possibility of the euro area

sovereign debt crisis resurfacing, the existence of downside risks to the world

economy, and the accumulation of household debt. Policy efforts, as set out

below, must therefore be strengthened to secure the stability of the financial

system even more firmly.

151

3. Current Status of Global Financial Regulation

3.1 Contents of Global Financial Regulations

3.1.1 Capital Regulations

In order to enhance loss absorption and reduce procyclicality, Basel III

has strengthened the minimum capital requirements, introduced capital buffers,

and implemented leverage regulation.

To strengthen the minimum capital requirements, Basel III requires banks

to maintain sufficient high-quality capital through increasing their common

equity tier 1 (CET 1) capital; introduces qualifying criteria; and enlarges the

scope of deduction for goodwill, deferred assets, and treasury stocks, etc.

Basel III includes two capital buffers, a capital conservation buffer and

a countercyclical buffer. Banks must build up capital conservation buffers

amounting to 2.5% of CET 1 during non-stress periods and can draw down

their accumulated buffers as losses are incurred. To ensure that banks set

aside the buffer, capital distribution constraints will be imposed on banks

whose capital levels fall within a specified range. The countercyclical buffer

meanwhile aims to ensure that the banking sector capital requirements take

account of the macro-financial environment in which banks operate. Banks

are subject to accumulation of countercyclical buffers from 0 to 2.5% of

their total RWAs (risk-weighted assets) in normal times, which they then

deploy in periods of stress.

A leverage ratio regulation (Tier 1 capital/Total assets e” 3.0%) has

also been implemented to regulate the excessive accumulation of leverage

by supplementing the existing risk-based capital regulation. This regulation

is based on the recognition that financial institutions’ excessive build-up of

leverage worked as a major factor behind the global financial crisis.

152

3.1.2 Liquidity Regulations

To enhance global consistency in liquidity management and banks’

resilience to a liquidity crisis, Basel III introduces two new liquidity regulation

criteria: the liquidity coverage ratio (LCR) and the net stable funding ratio

(NSFR).

The LCR “aims to ensure that a bank maintains an adequate level of

unencumbered, high-quality liquid assets that can be converted into cash to

meet its liquidity needs for a 30-calendar-day time horizon under a significantly

severe liquidity stress scenario specified by supervisors. As a minimum, the

stock of liquid assets should enable the bank to survive until Day 30 of the

stress scenario, by which time it is assumed that appropriate corrective actions

can be taken by management and/or supervisors, and/or the bank can be

resolved in an orderly way”2. This standard will be implemented in 2015

after a period of monitoring from 2011 to 2014.

Table 2

Basel II and Basel III Capital Regulation Comparison

________________

2. “Basel III: International Framework for Liquidity Risk Measurement, Standards and

Monitoring,” BCBS, Dec. 2010.

153

There are two categories of assets that can be included in the stock of

high-quality liquidity assets. Assets to be included in each category are those

that the bank is holding on the first day of the stress period. “Level 1”

assets can be included without limit, while “Level 2” assets can only comprise

up to 40%3 of the stock. All high-quality liquid assets should ideally be central

bank eligible for intraday liquidity needs and overnight liquidity facilities in

a jurisdiction and currency where the bank has access to the central bank.

The term total net cash outflows4 is defined as the total expected cash

outflows5 minus total expected cash inflows6 in the specified stress scenario

for the subsequent 30 calendar days.”

________________

3. The calculation of the 40% cap should take into account the impact on the amounts

held in cash or other Level 1 or Level 2 assets caused by secured funding transactions

(or collateral swaps) maturing within 30 calendar days undertaken with any non-Level

1 assets. The maximum amount of adjusted Level 2 assets in the stock of high-quality

liquid assets is equal to two-thirds of the adjusted amount of Level 1 assets after

haircuts have been applied. (“Basel III: International Framework for Liquidity Risk

Measurement, Standards and Monitoring,” BCBS, Dec. 2010).

4. Where applicable, cash inflows and outflows should include interest that is expected

to be received and paid during the 30-day time horizon.

5. Total expected cash outflows are calculated by multiplying the outstanding balances

of various categories or types of liabilities and off-balance sheet commitments by the

rates at which they are expected to run off or be drawn down.

6. Total expected cash inflows are calculated by multiplying the outstanding balances of

various categories of contractual receivables by the rates at which they are expected

to flow in under the scenario up to an aggregate cap of 75% of total expected cash

outflows.

154

Table 3

High-Quality Liquid Assets

155

The NSFR has been introduced to promote more medium- and long-

term funding of the assets and activities of banking organisations. This

standard establishes a minimum acceptable amount of stable funding based

on the liquidity characteristics of an institution’s assets and activities over

a one-year horizon.

In particular, the NSFR standard is structured to ensure that long-term

assets are funded with at least a minimum amount of stable liabilities in

156

relation to their liquidity risk profiles. The NSFR aims to limit over-reliance

on short-term wholesale funding during times of buoyant market liquidity

and encourage better assessment of liquidity risk across all on- and off-

balance sheet (OBS) items. The NSFR is defined as the ratio of the available

amount of stable funding to the required amount of stable funding:

Available stable funding (ASF) is defined as the total amount of a bank’s:

(a) capital; (b) preferred stock with maturity of equal to or greater than one

year; (c) liabilities with effective maturities of one year or greater; (d) that

portion of non-maturity deposits and/or term deposits with maturities of less

than one year that would be expected to stay with the institution for an

extended period in an idiosyncratic stress event; and (e) the portion of

wholesale funding with maturities of less than a year that is expected to

stay with the institution for an extended period in an idiosyncratic stress

event.

The required amount of stable funding is calculated as the sum of the

value of the assets held and funded by the institution, multiplied by a specific

required stable funding factor assigned to each particular asset type, added

to the amount of OBS activity (or potential liquidity exposure) multiplied by

its associated RSF factor.

The RSF factors assigned to various types of assets are parameters

intended to approximate the amount of a particular asset that could not be

monetised through sale or use as collateral in a secured borrowing on an

extended basis during a liquidity event lasting one year. Under this standard,

such amounts are expected to be supported by stable funding.

3.2 Current Status of Compliance by Korean Banks

3.2.1 Status of Capital Regulation Compliance

Korean banks exhibit good capital conditions considering that their BIS

ratios stood at 13.8% on average as of the end of June 2012. The Korean

banks’ BIS ratio have maintained a stable trend since rising sharply from

10.9% to 14.7% in the September 2008 to March 2010 period, due to risk-

weight reductions and capital enhancement through capital increases, and

157

internal reserves. Their Tier 1 capital ratio has also risen to 11.03%0at end

June 2012 after recording 8.33% as of end June 2008.

From the standpoint of capital composition, the Korean banks can be

assessed as in good condition due to their high ratios in Tier 1 capital of

common capital. The Korean banks exhibit a higher Core Tier 1 capital ratio

at 10.73%, than the average among the major international banks of 9.95%,

while their BIS and Tier 1 capital ratios are a bit lower than those of the

major international banks.

Chart 8

Source: The Banker.

The results of a quantitative impact study (QIS) executed by the BCBS

suggest that Korean banks’ additional financial burdens needed to satisfy

the enhanced capital regulations may not be sizable. As of end 2009, Korean

banks7 exhibited a CET 1 ratio of 10.3%, a Tier 1 ratio of 10.4%, and a total

capital ratio of 13.5% - all are much higher than the minimum Basel III

requirements of 7.0%, 8.5%, and 10.5%, respectively. Their average leverage

ratio, at 4.6%, was also much higher than the 3.0% minimum requirement.

It is however expected that Korean banks may face additional capital

burdens if the Korean supervisory authority enhances the domestic rules

and makes them stronger than the international rules, or imposes additional

capital requirements on D-SIBs (domestic systemically important banks).

________________

7. Eight major Korean banks.

158

3.2.2 Status of Liquidity Regulation Compliance

The QIS also found that the Korean banks’ average LCR and NSFR

fall short of the minimum requirements of 100%. The average LCR and

NSFR of the major Korean banks were 76% and 98%, respectively, a bit

lower than that of the major international banks.

4. Effects of Basel III Capital Regulations

4.1 Effects on Banks’ Behaviour

It is possible that the Korean supervisory authority will impose stricter

ruling on the Korean banks than the international rules. In this case, Korean

banks may respond by either enhancing their capital or reducing their risk-

weighted assets:

Table 4

Basel III Liquidity Ratios (%)

Notes: 1) Internationally active banks having more than 3 billion euros of Tier

1 capital; the Korean bank targeted by the QIS were Woori, Shinhan,

Hana, KB, and IBK.

2) The Korean banks targeted were Daegu and Busan.

3) End 2009basis.

Source: Financial Supervisory Service.

159

Chart 9

Banks Options for Raising BIS Ratio

* BIS capital ratio = Regulatory capital / Risk-weighted assets.

The amounts of capital required in order for the Korean banks to meet

the possible enhanced capital regulations will vary depending on the target

capital ratio. If the target ratio (Basel III basis) is set at 13.0%, including

the countercyclical buffer, then the amount of required capital is estimated

at 16.6 trillion won. If the ratio is set at 14.6%, which was the average total

capital ratio of the Korean banks in 2010, the amount of required capital is

estimated at 34.3 trillion won.

If banks procure this capital through internal reserves, it is envisaged

that the banks need three to five years to reach the target level. The Korean

banks will usually procure capital through internal reserves rather than by

issuance of new stocks. New stock issuance costs much more than other

funding methods, and is hard to do often as it requires consideration of many

factors, such as stock market conditions and the possibility of declines in the

price of the existing shareholders’ stock holdings.

If the capital regulations are enhanced, the banks’ Treasury Bill (TB)

investments is expected to increase due to their portfolio adjustments carried

out to reduce risks. Since the global financial crisis, the volume of Korean

banks’ risk-weighted assets has fallen steadily while their total asset volumes

have exhibited stable behaviour. This means that the Korean banks have

replaced some of their high-risk assets with lower-risk ones.

160

4.2 Effects on Financial Markets

Given banks’ expected responses to the capital regulation enhancement,

such as, for example, increases in capital and reductions in RWA, several

developments in the Korean financial markets can also be anticipated,

including a widening of the spread between the lending and deposit rates,

a contraction in loans, and an expansion of the credit spreads.

Korean banks may widen their spreads between their lending and deposit

interest rates to reflect their costs due to the capital regulatory strengthening.

In such a case, they will try to do so by hiking the lending interest rates

rather than by cutting the deposit interest rates. Considering this effect of

Basel III, it seems reasonable to expect the trends of loan interest rate

increase and loan-to-deposit rate spread enlargement since early 2009 to

continue for some time, barring any changes in external conditions, such as

occurrence of an economic boom.

Loans mainly to SMEs are likely to be reduced due to stiffening in banks’

lending attitudes. This may lead to an increase in shadow banking loan

demands, and work to boost the sector’s share in the Korean loan market.

Chart 10

Note: The figures in ( ) indicate the

proportions in the total amount

of funds

Source:BoK. Source: BoK.

161

The credit spread between safe assets such as TBs and risky assets

may also widen, in line with increasing downward pressures on the TB interest

rates stemming from the banks’ preference for safe assets.

4.3 Effects on Economic Growth

The existing literature analysing the effects of capital regulation

enhancement at the macroeconomic level generally concludes that capital

regulation enhancement may cause a may cause a slowdown in economic

growth due to increases in lending rates and decreases in loan interest

rates and decreases in loan volume.

In its analysis, the Macroeconomic Assessment Group (MAG)8 assessed

the impact of the capital regulation enhancement on the global economy as

likely to be modest. Assuming a steady increase in capital requirements

amounting to a total 1%p after eight years, it expected the level of global

GDP to fall by a maximum of 0.15% after 35 quarters, compared to that

before the capital regulation enhancement.

Chart 11

Source: BOK. Source: BOK.

________________

8. The FSB and the BCBS established the MAG in Feb. 2012, to assess the Basel III

regulations’ macroeconomic impacts.

162

There are other approaches besides that of the MAG to measure the

impacts of capital regulation enhancement on the economy. Barrel et al.

(2011) showed, from an analysis of 713 banks in the OECD countries between

1993 and 2007, that a rise in the minimum regulatory capital ratio induces

a bank propensity for risk aversion. Cosimano and Hakura (2011) suggested

after analysing 100 major international banks that, the long term, the loan

interest rates will rise by 16bp and loan volumes decrease by 1.3% owing

to the Basel III capital regulatory enhancement. Angelini et al. (2011)

estimated that the level of the global GDP will fall by 0.09% from its baseline

projection due to a 1%p increase in the minimum regulatory capital ratio.

In this paper, an attempt to measure the impacts of the Basel III capital

regulations on the Korean economy by applying the MAG methodology has

been tried. The MAG used a two-step approach to assess these impacts –

first, estimating the changes in lending spread and volume caused by a

regulatory capital ratio increase, and then measuring the impacts on GDP

using these estimated changes:

Table 5

Global Macroeconomic Impacts

* Macroeconomic impacts of 1%p increase in regulatory capital ratio.

163

The results of the estimation applying the MAG methodology to the

Korean economy established that the GDP can fall by 0.23% compared to

its baseline due to a 1%p increase in the regulatory capital ratio. The changes

in the lending spread is calculated as the range of the lending interest rate

increase necessary to offset the decline in ROE due to the regulatory

enhancement9, while the changes in lending volume is estimated through a

regression analysis between the regulatory capital ratio and the lending

volume. The changes in GDP, lastly, are estimated using BOKDPM, a

macroeconomic analysis model of the BOK.

The lending spread rises by 25bp in response to a 1%p increase in the

regulatory capital ratio. The lending attitude at the same time exhibits a

somewhat stiffening tendency, with the lending attitude index falling from

0.0 to –7.7410. Due to the resulting changes in the price and volume of

lending, it is estimated that the GDP level will fall by a maximum of 0.23%

after 35 quarters, assuming that the regulatory capital ratio is increased

steadily during the period of 2011-2018 by a total 1%p:

Chart 12

Macroeconomic Impact Analysis Process

________________

9. “The impact of changing capital and liquidity requirements on lending rates: some

estimates based on accounting identities”, MAG, 2010.3.

ROE = ROA x leverage

Banks will try to raise their ROAs to offset decreases in ROE caused by reductions

in leverage due to regulation enhancement. While ROA can also be increased by cutting

funding costs through a reduction in leverage, this analysis does not consider that

effect.

10. The index has a value between –100.0 and +100.0, with 0.0 indicating maintenance of

the status quo, -100.0 complete stiffening, and 100.0 complete easing.

164

Chart 13

Estimation of Capital Regulation Impacts on Macroeconomy

Notes: 1) Assuming gradual adjustments of lending spread and volume.

2) The numbers given are the largest decreases in GDP level (gap ratio) following

the regulation strengthening (after 35 quarters).

3) Assuming policy rate adjustment by the monetary authority in response to

business fluctuations due to capital regulation enhancement.

165

4.4 Banks’ Risk Management Behaviour and Effects of

Countercyclical Capital Buffer

The estimation conducted above did not consider variation in banks’

responses to capital regulation enhancement would depend on their financial

situation. Naturally banks will of course respond differently to the regulations

depending on their financial states and market conditions, and the resulting

policy effects may thus diverge from the authorities’ intent. This situation

can be verified by measuring the effects of the countercyclical capital buffer,

newly implemented under Basel III, in consideration of the banks’ responses.

A look at the trend of Korean banks’ regulatory capital ratio

(K = E / ω A) shows that, unless changes occur in external conditions, such

as regulatory policy, they adopt a risk management behaviour of generally

maintaining a certain consistent level11 of K (K = K*) except for the period

2004 to 2005 when banks reset their target regulatory capital ratios in

response to the capital regulation tightening. K remained stationary near to

the minimum requirements of 10% prior to 2003 and 12% after 2005. After

2007, the Korean banks then experienced sharp up and down fluctuations

in K, due to the global financial crisis and to their preparations in advance

for the Basel III implementation:

________________

11. If a bank has a capital ratio higher than the regulatory level, it must pay the opportunity

costs of holding excessive capital. On the other hand, if the actual capital ratio is below

the regulatory level, the bank will be penalised by the supervisory authority. Thus,

there are sufficient reasons for banks to maintain their capital at the required level.

166

Chart 14

Trend of K of Korean Domestic Banks

Source: Financial Supervisory Service, BOK.

These tendencies of the Korean banks can be confirmed by a hypothesis

test. In this test, the null hypothesis is accepted for the stable periods but

rejected in the adjustment periods, with significance level of 5%. It is thus

possible to expect that the Korean domestic banks will maintain their K at

the target level of K* - unless unanticipated events arise. Note that when

banks keep their capital ratios at the target level, a stable relationship between

Table 6

Hypothesis Test Results

* When P = 5%, the null hypothesis (H0) is rejected.

167

regulatory capital and assets exists because the risk weight remains stable:12

These risk management behaviours may induce procyclicality. If K deviates

from its target level, K*, with changes in its components (E, ω, A), banks

adjust the components to meet the condition again. In this process banks’

assets, A, fluctuate; and fluctuations in will cause fluctuations in A the

volume of credit provision to the real sector by the banks, which may ultimately

induce procyclicality and amplify fluctuation of the business cycle in the real

sector.

To examine this process in more detail, it is necessary to check the

correlations among the components of the regulatory capital ratio, K, E and

A, the major factors causing K to fluctuate, exhibit a nearly perfect positive

correlation with a coefficient of 0.98. A Granger causality test between and

, changes in E and A, respectively, shows that causes with a one-year

lag while there is no causality in the opposite direction:

________________

12. Because the regulatory capital ratio consists of equity, assets and risk weight

( ), the stable relationship between changes in equity and assets holds only

when the risk weight is also stable:

* The correlation between K and λ is a

comparatively high 0.87.

168

These results imply that changes in K are generally induced by E, while

adjustments K in are made mainly through modifications of A :

Chart 15

Source: BOK.

Based on the results of this analysis, it is understood that the risk

management behaviours of the Korean banks, of maintaining their capital

ratios at the regulatory level by adjusting their assets in response to capital

fluctuations, may induce procyclicality. It is therefore possible to capture the

factors causing procyclicality by examination of the factors behind fluctuations

in capital.

Korean banks, during boom times13, will typically raise E with retained

earnings instead of through issuance of equity. Because the Korean banks

Chart 16

The Transmission Process of Change

________________

13. A boom time is a period during which the rate of growth in profits exceeds its long-

term average.

169

have a relatively low level of propensity to pay dividends14 their profits usually

serve as the main factor driving changes in their retained earnings. And

profits move procyclically largely because of the strong inherent procyclicality

of loan loss provisions. Provisions increase (decrease) during recessions

(booms), with the resulting increases (decreases) in loan losses. These

procyclical movements of the provisions feed into profits and retained

earnings, causing and to accordingly reveal procyclicality:

For Korean banks, provisions contribute 71.8% on average to the

increases in profits seen during boom15 times and 123.0% to their decline

during recessions. Among the other components, interest incomes shows a

Chart 17

Contributions to Changes in Equity

________________

14

Notes: 1) Dividends / Profit

2) Top three banks of each country

15. The boom and recession is decided by the sign of growth rate to the previous year.

Comparison of Propensities to Pay

Diividends1)

170

continuous rise irrespective of the business cycle, and so while it may thus

contribute to the increase of profits in a boom, it has a negative contribution

during recession. Fees and valuation profits meanwhile do not contribute

much to profit variation:

The mechanism that generates procyclicality in bank assets can thus be

summarised as follows. First, fluctuations in the real sector cause changes

in bank profits. Banks try to maintain their capital ratios at the target level

in response for risk management. This management behavior induces changes

in bank assets that generate fluctuations in the aggregate credit supply,

amplifying the business cycle:

Table 7

Contributions to Changes in Profits(%)

Chart 18

Mechanism of Procyclicality Inducement by Risk Management

Due to the risk management behavior described above, the effects of

the countercyclical capital buffer may deviate from the supervisory authority’s

expectations. In response to the imposition of the countercyclical buffer, banks

can choose other options besides reducing assets, the option desired by the

supervisory authority, depending on the size of their adjustment costs. If

such is the case, the effects of the countercyclical buffer can be limited.

171

Three options are available to the banks for complying with an increased

regulatory capital ratio imposed by the authorities to restrain credit supply

during boom times: 1 capital (E) expansion; 2 risk weights (µ) reduction;

or 3 assets (A) reduction.

Banks will choose the option that is least expensive in terms of their

adjustment costs. The adjustment costs can be measured as the differences

between the optimal economic value added (EVA) before introduction of the

countercyclical buffer and the changed EVA due to the options taken in

response to the buffer. They are calculated by adjustment size (i.e. the degrees

of deviation of the B/S items from their optimal levels due to the regulations)

and by unit costs, (i.e. the costs of adjusting individual units of the balance

sheet items concerned):

• EVA = Operating Profits – Liability Costs – Capital Costs

= (Assets× Rate of Return) – (Liability× Funding Costs) – (Capital×

Funding Costs)

• Adjustment costs = Optimal EVA (before regulation) – Optimal

EVA (after regulation)

= Adjustment size × Unit Costs

Chart 19

Effects of Imposing Countercyclical Buffer

A simulation based on the banks’ position as of end 2010 shows that the

Korean banks may choose to expand their equity when the countercyclical

buffer is imposed. Among the different adjustment costs, those required by

this option are the lowest (0.46 trillion won), below the cost of reducing

either (0.70 trillion won) or risk weights (0.93 trillion won):

172

Table 8

Adjustment Costs of Options for Responding

to Countercyclical Buffer Imposition

(End-2010)

In 2003, following the supervisory authority’s recommendation to raise

the capital ratio from 4.5% to 5.5%, the Korean banks actually responded

by enlarging equity and reducing the rates of increase in their assets

simultaneously.

5. Effects of Basel III Liquidity Standards

5.1 Effects on Banks’ Behaviour

Korean banks are expected to try to attract retail, and small- and medium-

sized enterprise deposits, which are more favourable for LCR and NSFR

calculation16. Especially, they are likely to try to attract stable deposits linked

to incomes, since the run-off rate applied to these deposits in the calculation

of the LCR is applied the lowest rate at 5%. Among the large enterprises

deposits, “deposits having operational relationships” will be preferred due to

their comparatively low run-off rate of 25%. The incentive for issuance of

financial debentures, on the other hand, whose issuance amounts have

decreased due to the Korean supervisory authority’s regulation of the deposit-

to-lending ratio since December 2009, will decline as they are not be admitted

as high-quality liquid assets in the calculation of the LCR17.

_________________

16. Retail, small- and medium-sized enterprise deposits are applied low run-off rates of

5% or 10% in calculation of the LCR, and high ASF factors of 80% or 90% in calculation

of the NSFR.

17. Under Basel III “CPs over AA-” are recognised as high-quality liquid assets, while bank

bonds are not included because they can cause spillovers in a crisis due to

interconnectedness among financial institutions.

173

While trying to attract SME deposits, which are advantageous in

calculation of the NSFR due to their comparatively stable character, the

Korean banks will also attempt to extend their funding maturities to meet

the NSFR requirements. To this end, the banks will try to raise the proportions

of their longer-maturity time and periodic deposits relative to demand deposits,

like MMDAs, and the demand for issuance of long-term bank bonds will

increase.

Table 9

Effects of Liquidity Regulation on Funding Through Deposits

(%)

Notes: 1) Including deposits for custody, clearing and settlement, cash management, etc.

2) Non-collateral wholesale funding basis

3) Existing maturity basis

174

Due to saturation in the personal, small deposit market, the Korean banks

will also try to attract large volume deposits from enterprises and households

which are more favourable in NSFR calculation. Between enterprises and

households, banks may in this regard prefer deposits by enterprises, which

are usually much larger18 than those of households. And among households,

banks will work to enhance their business services for wealthy customers,

such as private banking.

Chart 20

________________

18. The cash amounts including cash equivalents deposited by Korean enterprises registered

in the Korean stock market had risen to 109 trillion won by 2010, from 53.2 trillion

won in 2005.

Notes: 1) Issue maturity basis

2) Figures in ( ) represent the

proportions in total bank bonds (%).

Notes: 1) Contract basis

2) Figures in ( ) represent the

proportions in total deposits (%).

175

To raise their LCR ratios to the minimum required 100%, the Korean

banks will in addition expand their fund operations in TBs and Monetary

Stabilisation Bonds (MSBs), to which 0% haircuts are applied, while reducing

their investment in bank bonds and CP rated below AA-, which are excluded

from high-quality liquid assets. In the case of New Zealand, which introduced

its own liquidity regulation preparatory to implementation of Basel III, banks’

TB holdings increased sharply from 0.7% at the end of 2008 to 4.2% as of

end November 2011.

To satisfy the regulatory standards, the Korean banks may also try to

reduce their lending to SMEs. If they expand their holdings of high-quality

liquid assets such as TBs to enhance their LCRs, the share for lending in

total capital operations will be relatively reduced. And in this case, the banks

will first reduce their loans to SMEs, which are unfavourable in NSFR

calculation. For NSFR denominator calculation, SME loans, which have a

RWA of 35% are given a 85% RSF factor, while the RSF factor applied to

housing mortgage loans is 65%.

5.2 Effects on Financial Markets

Looking at the Korean money markets, it is expected that the CP market

will contract due to Korean banks’ reductions in purchase commitments on

which a 100% run-off rate is applied and shortening of maturities. Other

money markets, such as the call and CD markets will meanwhile be stable.

Chart 21

Note: Figures in ( ) are the proportions in

total time deposit volumes (%).

Note: Year-on-Year Changes.

176

Call operations are executed mainly for the purpose of reserve adjustment

and the CD market has contracted already due to the loan-to-deposit ratio

regulation. Demand will increase in the TB and MSB markets as banks will

convert their bond holdings to high-quality liquid assets to raise their LCR.

Korean banks’ total bond holdings amounted to 215 trillion won as of end-

2010, and they needed 43.5 to 44.2 trillion won of additional high-quality

liquid assets to meet the LCR standards.

In the case of the TB market, meanwhile, when the liquidity standards

are implemented, demand may come to predominate and this increased

demand may put downward pressure on TB yields.

The bank bond markets are expected to contract due to a decline in

banks’ investment demand, while demand discrimination between prime and

non-prime CP in the CP market is also anticipated. The reduced investment

demand for bank bonds may work as a factor widening credit spreads between

bank bonds and TBs, and the bank bond yield curve may steepen due to the

issuance of bank bonds mainly on a long-term basis. Meanwhile, banks’

preference for prime CP may induce an expansion in spreads based on credit

ratings. Additionally, if MSBs issued by the Korea Housing Finance

Table 10

Note: End-2010.

Source: BOK.

Notes: 1) End-2010.

2) RPs, Stocks, Bills bought in won.

Source: BOK.

177

Corporation are admitted as high-quality liquid assets, Korean banks will

find it easier to raise their LCRs through MSB securitisation, and the KHFC

will come to increase its MSB issuance as a result.

6. Policy Implications and Conclusions

The global financial regulatory reform encourages changes in banks’

business models, and these changes may affect the financial markets and

ultimately the real sector. By increasing Korean banks’ preference for safe

assets, the Basel III liquidity standards are expected to lead to declines in

TB/MSB interest rates and expansions in credit spreads. As Korean banks

try aggressively to expand their capital due to capital regulatory enhancement,

increases in lending rates and a contraction in the loan market are expected.

Especially, if competition among banks to attract deposits increases after

the introduction of the liquidity standards, the stability of the monetary policy

transmission channel may erode due to increases in deposit interest rates

and to expanded financial market volatility. It will thus be necessary for

central banks to examine these changes in the monetary policy transmission

channel carefully and consider them in their policy decisions. Given the

expected SME difficulties in obtaining bank financing post-reform, it will

also be necessary to arrange plans to stimulate financial support for the

SMEs, for example by allowing issuance of P-CBOs based on SME CP and

arranging recognition of them as high-quality liquid assets.

A countercyclical capital buffer has been newly introduced in Basel III.

Detailed plans for its implementation, however, including on the method of

its accumulation and guidance on its use is left to each jurisdiction’s decision.

For effective application of the countercyclical buffer, it is of utmost

importance that reference indexes be developed concerning the beginning

point of accumulation, the proper buffer level, etc. Cooperation and division

of roles between the central banks and supervisory authorities are in addition

necessary for effective buffer operation. This is because for successful

implementation of the countercyclical capital buffer, harmonisation of

judgement and management are required from both the micro and the macro

perspectives. A recommendable division of roles is for central banks to take

charge in macro-prudential areas and for the supervisory authorities to handle

the micro-prudential regulations and follow-up management. The

countercyclical buffer’s policy effects may meanwhile deviate from those

expected or be limited by banks’ responses to it, as well as by the financial

and economic conditions. In developing a model for countercyclical buffer

operation model, it is therefore necessary to set a device for considering

178

financial and economic conditions. And given the evidence in the example

of the Korean banking sector that the loan loss provisions work as a core

factor inducing procyclicality, dynamic provisioning can be an alternative when

the capital buffer’s effects are limited by banks’ responses. Policy measures

to control banks’ assets, such as the LTV ratio regulation, and to directly

affect banks’ profits, such as the reserve ratio, are meanwhile also available

to supplement the countercyclical capital buffer.

Excessive bank competition for deposits due to the liquidity regulation

can cause deposit interest rates to rise and induce increases in lending rates,

or encourage more aggressive risk-taking behavior on the part of the banks.

Deposits attracted by the raising of interest rates, such as large volume

deposits by enterprises, are however apt to run off more easily than retail

deposits, a propensity that may work as a potential risk factor during crisis.

Proper monitoring of excessive competition is thus needed to prevent the

related financial risk in advance.

Because the Basel framework is applied only to the banking sector, the

appearance of regulatory arbitrage between the banking and shadow banking

sectors is possible. To prevent systemic risks, it is thus needed to monitor

potential risk factors from the perspective of the system as a whole and to

identify the channels of risk transmission between the banking and shadow

banking sectors.

179

References

Adrian, T. and H.S. Shin, (2008), “Liquidity and Leverage,” Staff Reports, 328,

Federal Reserve Bank of New York.

Basel Committee on Banking Supervision (BCBS), (2008), Principles for Sound

Liquidity Risk Management and Supervision, September.

Basel Committee on Banking Supervision (BCBS), (2010), Basel III: International

Framework for Liquidity Risk Measurement, Standards and Monitoring,

December.

Basel Committee on Banking Supervision (BCBS), (2010), Basel III: A Global

Regulatory Framework for More Resilient Banks and Banking Systems,

December.

Bank for International Settlements, (2010), An Assessment of the Long-term

Economic Impact of Stronger Capital and Liquidity Requirements.

Bank of Korea, (2012), Financial Stability Report, April.

Bank of Korea, (2011), Financial Institutions in Korea.

Bini Smaghi, Lorenzo, (2010), “Basel III and Monetary Policy,” Speech at

International Banking Conference.

Chakrabarty, K.C., (2011), “Introduction of International Financial Reporting

Standards (IFRS) –Issues and Challenges,” BIS Central Bankers’ Speeches,

BIS.

Craig, Ben R. and Valeriya Dinger, (2010), “Deposit Market Competition,

Wholesale Funding, and Bank Risk,” European Banking Centre

Discussion Paper, No. 2010-17S.

Drehmann, Mathias; Claudio Borio; Leonardo Gambacorta; Gabriel Jiménez and

Carlos Trucharte, (2010), “Countercyclical Capital Buffers: Exploring

Options,” BIS Working Paper, No. 317.

FSB, (2011), Covered Bonds and Asset Encumbrance: Medium-term Challenges

from the Recent Surge in Banks’ Covered Bond Issuance.

180

Hannoun, Hervé, (2011), “Towards a Global Financial Stability Framework,”

Speech at 45th SEACEN Governors’ Conference, 26–27 February.

Heid, Frank and Ulrich Krüger, (2011), “Do Capital Buffers Mitigate Volatility

of Bank Lending? A Simulation Study,” Discussion Paper Series 2, No.

03/2011, Deutsche Bundesbank.

Mayer Brown, (2009), “US Department of Treasury Public-Private Investment

Program – Opportunities, Issues and Considerations for Fund Sponsors

and Investors,” Corporate White Paper,.

Michael R. King, (2010), “Mapping Capital and Liquidity Requirements to Bank

Lending Spreads,” BIS Working Papers, No. 324.

Nout Wellink, (2011), “Basel III and the Impact on Financial Markets,” Speech

at ING Basel III Financing Conference.

P. Angelini; L. Clerc; V. Cúrdia; L. Gambacorta; A. Gerali; A. Locarno; R.

Motto; W. Roeger; S. Van den Heuvel and J. Vlèek, (2011), “Basel III:

Long-term Impact on Economic Performance and Fluctuations,” BIS

Working Papers, No. 338.

Repullo, Rafael and Jesus S. Salas, (2011), “The Countercyclical Capital Buffer

of Basel b!: A Critical Assessment,” Discussion Paper, No. 8304, Centre

for Economic Policy Research.